Taxation of a pagdi flat in Mumbai under redevelopment

What is the Pagdi System that is mainly prevalent in Mumbai?

The term "Pagdi" holds significant cultural and legal weight in the real estate landscape of Maharashtra and other parts of India. Stemming from a unique tenancy arrangement, the Pagdi system embodies a symbiotic relationship between landlord and tenant, marked by a lump sum payment, typically known as "pagdi," and subsequent nominal rent payments for property usage. In essence, the Pagdi system confers upon the tenant certain inheritable and transferable rights akin to ownership, albeit without formal title deeds. This distinctive characteristic allows tenants to pass on their pagdi rights to descendants or even sell them to interested parties, rendering it an integral part of the socio-economic fabric in regions where it is prevalent.

Unlike traditional rental agreements with intricate legal formalities and higher rents, the Pagdi system offers a more straightforward and cost-effective alternative. By paying a lump sum "pagdi" amount upfront, tenants gain long-term occupancy rights with nominal rent obligations. This arrangement caters to the needs of those who prioritize simplicity and affordability in their housing choices, without entangling themselves in the complexities of property ownership. Thus, in today's dynamic real estate scenario, the Pagdi system continues to fulfill a crucial need, providing a practical and accessible housing solution for the transient working-class population in metropolitan areas.

The tenant is entitled to remain in possession of the tenanted premises?as a statutory tenant?so long as he continues to pay the agreed rent together with the permitted increases and also observes the other conditions laid down under the Bombay Rent Act.?

Pagdi of the property is only in relation to the tenancy and possessory rights to occupy the property and the same is not equivalent to the legal ownership of the property.

Pagdi System & Redevelopment

The tenants living with pagdi system in non-cessed buildings before June 13, 1996, are eligible for new flats whenever their building is redeveloped according to new guidelines introduced by the BMC. In addition, if a tenant has transferred the pagdi system flat in the name of another person after completing the required legal formalities, the new occupant will have equal rights and will be eligible to get accommodation after redevelopment.

Clause 4 is modified specifies that no new tenancy created after 13/6/96 shall be considered. Further, unauthorized construction made in buildings for creating new tenancy in the existing tenancies shall not be considered while doing computation of existing FSI.?

According to the new DCPR - 2034, whatever the total area the landowner needs to rehabilitate the existing tenants, he will get half of that area in form of additional construction rights to recover the construction cost and his profit.

The rules further state that the tenants are entitled to get more area than they currently occupy minimum area will be 300 sq. ft and maximum 1,292 sq. ft free of cost. If their area crosses the maximum cap, the tenant will have to pay construction cost of the additional area to the landowner.

Civic officials stated the attractive incentives make redevelopment a win-win situation for everyone as residents stand to get bigger houses.

Taxation Aspects

A tenancy right is a capital asset and transfer of a capital asset yields capital gains.

LTCG Impact

1.????? What if Tenant continues as Tenant with additional Areas?

There are no significant implications for the Tenant, as there appears to be no "Transfer" involved; the Tenant's status remains unchanged. The only difference is that the Tenant gains additional area without incurring any additional cost. This situation is akin to a woman changing the design of her jewelry to keep up with fashion trends. However, Tenants are advised to consult their Chartered Accountants (CAs) and review all signed documents to ensure they fully understand the implications and compliance requirements.

2.????? What if Tenant receives Redeveloped Flat as “Owner” with additional Areas?

Previously, the Tenant held tenancy with "possessory" rights, allowing them to "occupy" the property. This form of tenancy is not equivalent to legal ownership of the property. Now, if the Tenant receives a redeveloped flat as the "Owner," their status changes from a "Tenant" to an "Owner."

In the context of Pagdi redevelopment, this shift means that the Tenant transitions from having limited rights and responsibilities under a tenancy agreement to holding full legal ownership of the property. As an Owner, the individual gains complete control and responsibility over the flat, including the additional areas received through the redevelopment. This change also confers new legal and financial responsibilities, such as property taxes, maintenance costs, and compliance with homeowners' regulations.

Tenants undergoing this transition should thoroughly review the terms and conditions of their new ownership status (taking into account documents signed with original owner & Developer) and consult with CAs to fully understand the implications of becoming a property owner as this will be treated as ‘Transfer” by Income Tax Department.

Transfer in Relation to Capital Asset as per Income Tax

Section 2(47) of the Income Tax Act provides an inclusive definition of “transfer” in relation to a capital asset. The key points include:

1.?????? Sale, Exchange, or Relinquishment of the Asset: This involves any form of sale, exchange, or relinquishment of rights in the asset.

2.?????? Extinguishment of Any Rights Therein: This includes any act that results in the extinguishment of rights in the asset.

Explanation 2 to Section 2(47) further clarifies that ‘transfer’ includes and shall be deemed to have always included:

1.?????? Disposing of or Parting with an Asset or Any Interest Therein: This can be done directly or indirectly, absolutely or conditionally, voluntarily or involuntarily, by way of an agreement (whether entered into in India or outside India) or otherwise.

2.?????? Creating Any Interest in Any Asset in Any Manner Whatsoever: This includes any form of creation of interest in an asset, again, directly or indirectly, absolutely or conditionally, voluntarily or involuntarily, by way of an agreement or otherwise.

Thus, the conversion from tenancy to ownership is considered a “transfer,” making it liable to Long Term Capital Gains (LTCG).

Implications for Tenancy Rights (Pagdi System)

The transfer of tenancy rights, commonly known as Pagdi, is considered a capital asset under the Income Tax Act. Any gains from such transfers are subject to capital gains tax. The tax liability is determined by whether the gains are classified as long-term or short-term, which depends on the holding period of the asset.

In the case of Pagdi property, the holding period starts from the date on which the tenant receives “ownership” rights and compared to when original tenant had started Tenancy rights.. This typically occurs upon signing the Development Agreement, Permanent Alternate Accommodation Agreement (PAAA), and vacating the old tenanted property.

Therefore, tenants converting their tenancy into ownership should be aware that this conversion constitutes a transfer under income tax law, and they will be liable for long-term capital gains tax. Consulting with a Chartered Accountant (CA) is advisable to fully understand the tax implications and ensure compliance.

?How to Mitigate Long Term Capital Gains (LTCG) Tax?

Claim Benefits under Sections 54 and 54F (up to Rs. 10 crore)

a) Section 54: Under Section 54 of the Income Tax Act, an individual or Hindu Undivided Family (HUF) selling a residential property can avail of tax exemptions from capital gains if the gains are invested in the purchase or construction of another residential property.

b) Section 54F: Section 54F of the Income Tax Act offers tax exemptions on the capital gains earned from the sale of any asset if the proceeds are reinvested in a residential property.

Since the Tenant was not the owner of the flat in Pagdi property, they should avail benefits under Section 54F.

Steps to Mitigate LTCG Tax:

a)????? Availing Section 54F Benefits: The Tenant (now Owner) can seek benefit under Section 54F and get the entire LTCG exempt. It is crucial to ensure that the possession of the redeveloped flat is received within 36 months of the sale.

b)????? Timely Offering of LTCG: Since 2023, the Income Tax Department reflects all redevelopment-related transactions in Form 26AS (Annual Information Return) and expects the assessee to report these transactions for tax purposes. It is advisable for the Tenant to offer the LTCG in the year of signing all documents and vacating the flat and to claim the benefits under Section 54F.

c)?????? Handling Delays in Possession: The main issue arises if the developer delays the possession beyond 36 months, as this would mean non-compliance with the requirements of Section 54/54F. Tenants should keep evidence (such as correspondences with the builder, either directly or through a Project Management Consultant) explaining the reasons for the delay. This documentation can be presented to the Income Tax Officer (ITO) if a notice is issued due to the delay after three years.

Cautionary Notes:

a)????? After availing of the benefits under Section 54/54F, if you sell the redeveloped ownership flat within three years, the benefits would be withdrawn.

b)????? When selling the redeveloped flat after three years, the cost will be the Fair Market Value (FMV) taken while offering LTCG when the tenanted flat went for redevelopment.

By following these steps, Tenants can effectively mitigate LTCG tax and ensure compliance with Income Tax regulations. Consulting with a Chartered Accountant (CA) is highly recommended to navigate the complexities and optimize tax benefits.

3.????? What if You Were to En-cash Your Tenancy Rights before Redevelopment?

The Pagdi system pertains only to tenancy and possessory rights to occupy a property, which are not equivalent to legal ownership. At no stage do your grandmother, your mother, or you have legal ownership rights to the property, whether pre- or post-redevelopment. Furthermore, no alteration, modification, or transfer of tenancy rights will occur during redevelopment, and no consideration will be received by you against the same.

In such a case, the sale of Pagdi in the redeveloped property may be construed as the sale of tenancy rights. Since the Pagdi in the property has been held for over 50 years, it qualifies as a long-term capital asset (LTCA), and any gain arising from the sale will be considered long-term capital gain (LTCG).

Given that the tenancy/Pagdi right in the property is an LTCA, you can adjust the Cost of Acquisition (CoA) based on the applicable Cost Inflation Index (CII). Additionally, the cost can be increased for any expenses incurred for the improvement of the asset.

As per Section 55(2)(a) of the Income Tax Act, 1961, read with Section 49(1), the cost of acquisition for a capital asset being a tenancy right received through gift, will, succession, or inheritance should be the cost to the previous owner (i.e., the original tenant). If the LTCA (Tenancy or Pagdi) was acquired before April 1, 2001, the cost of acquisition shall be either the actual cost of the asset or the Fair Market Value (FMV) as of April 1, 2001. This value needs to be ascertained by obtaining a Valuation Report from an Income Tax Registered Valuer.

LTCG income would be taxable as per the provisions of Section 112 of the Act, i.e., at the rate of 20% plus applicable surcharge and Cess @ 4%.

Deductions from LTCG Income:

a) Under Section 54F: By investing the net sale proceeds in the purchase or construction of another residential property within the specified timelines (provided that the person doesn’t hold more than one property, in addition to the new house, on the date of sale of LTCA). If only a part of the net sale proceeds is invested, the deduction under Section 54F will be available only for the proportionate LTCG.

b) Under Section 54EC: A deduction of ?50 lakh is available towards investment in specified bonds. Although this deduction is generally towards the sale of a “residential house” under the Pagdi system, it is advisable to consult your CA before making a final decision.

By understanding and utilizing these provisions, you can effectively manage and mitigate LTCG tax liabilities when en-cashing tenancy rights before redevelopment. Consulting with a Chartered Accountant (CA) is highly recommended to ensure accurate compliance and to optimize tax benefits

CA Harshad Shah, Mumbai [email protected]